When making the case for a single, centralized sovereign to replace the system under the Articles of Confederation, Alexander Hamilton cited the loose eighteenth-century German confederation as an example of provincial sovereignty gone awry. He advocated a centralized system of finance and decision making that would relegate subnational governments primarily to the administration of policies conceived and funded by the center. Two hundred years later, the German federation is much closer to Hamilton's vision of centralized legislation and taxation than a “community of sovereigns.” Yet the German postwar constitution is nevertheless extremely federal in every respect outlined in Chapter 2. Above all, the Länder are very important players in the federal policy process, and the constitution provides them with a number of robust institutional safeguards.

This chapter expands on a key observation from Chapter 3 that was first suggested by Alexander Hamilton: Perceptions of the center's commitment not to intervene in subnational fiscal crises are shaped in large part by the intergovernmental fiscal system of taxes, revenue sharing, and transfers. A key argument in this chapter is that when subnational governments depend heavily on intergovernmental grants, loans, and revenue-sharing schemes as opposed to subnational taxes and fees, the central government's ex ante commitment to a policy of no bailouts lacks credibility. For a variety of reasons elaborated below, when a higher-level government has undertaken heavy obligations to fund the expenditures of lower-tier governments, doubts creep into the minds of voters, creditors, and local governments about the center's ability to withstand the political costs of allowing subnational governments to default.

Hamilton alluded to this problem when expressing concerns that the states presided over insufficient tax base to sustain sovereign borrowing, making the federal government – with its deeper pockets and good credit history – an implicit guarantor. He feared that after a negative shock, borrowing by the states under these circumstances was bound to culminate in a legislative battle over debt renegotiation. For him, the solution to this moral hazard problem was not to expand the taxes available to state governments in order to firm up their sovereignty, but rather to clamp down on their access to deficit finance by placing all public borrowing firmly under the control of the central government.

On July 2, 1997, Rerngchai Marakanond, the governor of the Thai central bank, announced that he did not control sufficient foreign reserves to defend his country's currency from speculative attacks. Whereas Asia had been an exceptionally popular destination for international capital in the mid-1990s, this date marked a decisive turning point in lenders' confidence in the region's economic prospects. International lenders began to shift their funds out of Asia in vast quantities. In countries where there were few rules restricting the movement of capital across borders, the outflow of capital was especially astounding. In the second half of 1997 alone capital outflows from these countries amounted to at least $34 billion. The currencies of many of these countries were subjected to devaluations of 40–80% in a matter of months, precipitating the collapse of several banking sectors and causing economic contractions of up to 15 percent of the gross domestic product.

In accounting for this crisis some scholars have focused on the dangers of allowing the liberal inflow of short-term loans; because such loans can be withdrawn rapidly, heavy exposure to these loans renders economies exceptionally vulnerable to sudden shifts in market sentiments. For these scholars the fundamental lesson to be learned from the Asian crisis is that developing countries should retain controls on international capital flows. However, other scholars have argued that the root causes of the crisis go far deeper.

This concluding chapter is divided into two sections. In the opening section, I summarize my results and address some of the implications and limitations of my analysis. In Section 7.2, I describe my agenda for future research.

SUMMARY OF RESULTS, IMPLICATIONS, AND LIMITATIONS OF ANALYSIS

In this book, I have attempted to advance the debate over capital flow liberalization in the developing world by studying the determinants of lax bank regulation under liberal capital flows. Aside from cronyism and gridlock, which have previously been identified, I identified a third causal path to lax regulation, namely, the path of incredible signaling. I showed that if a chief executive does not have the freedom to appoint an official who shares his preferences as a signaler of confidential bank regulatory information, the outcome will be an incredible long-term commitment to stringent bank regulation. Using the tools of game theory, I showed that the difference in preferences between a signaler and the chief executive that results in serious miscommunication is very small in the realm of bank regulation. I showed that miscommunication results in an incredible commitment to stringent regulation even in the presence of a chief executive who does not have close ties to bankers, by causing the chief executive to miscalculate his responses to shocks to the banking sector.

I then identified ways to solve signaling problems, such as appointing friends or close associates who share the chief executive's regulatory priorities to senior financial positions.

In this chapter, I show how a common understanding has emerged that lax bank regulation presents immense dangers for countries operating under liberal capital flows. I begin by presenting the neo-classical case for capital flow liberalization. I then describe the attack on this case following the Asian crisis. Finally, I describe how even prominent proponents of liberalization now accept that the success of liberalization may be contingent on stringent bank regulation.

Prior to the 1980s, most developing countries maintained a significant body of regulations limiting the inflow and outflow of capital across national borders. Foreign exchange transactions had to be approved by government officials and were subject to stringent limits, domestic banks were tightly restrained from borrowing from private sources overseas, and stock markets faced significant legal obstacles to accessing international funds. Starting in the 1980s, the International Monetary Fund (IMF) began to place immense pressure on developing countries to dismantle these and other barriers to the inflow and outflow of international capital. Four arguments, which are sometimes jointly referred to as the neo-classical case for liberalization, were offered in justification for this pressure.

First, it was argued that environments with liberal capital flows, referred to in short as environments with open capital accounts, would help developing countries gain access to funds from developed countries. This would enable them to achieve investment levels that exceeded their domestic savings rates, and thus help them grow faster in the long run.

In this chapter, I address the three countries in the sample that were democracies. At some point in time each of these countries had a chief executive without crony links to bankers, who was forced to operate with a signaler/signalers with regulatory preferences that were different from his own thanks to the checks on his power. On each occasion there is evidence of serious problems in communication that went unresolved, resulting in lax regulation. This, of course, is in line with the predictions of the theory.

THAILAND

Thailand proved to be an extremely lax regulator of banks in the wake of capital flow liberalization in the early 1990s. Prior to liberalization, however, Thailand's central bank was not considered to be an extremely lax regulator. To place Thailand's post-liberalization regulatory performance in context, I begin with a background section that addresses the political determinants of bank regulation in Thailand from the 1960s to liberalization. In Section 4.2, I describe the political environment in which Chuan Leekpai, the Thai prime minister for the three years following capital flow liberalization, operated. In Section 4.3, I describe Chuan's inner circle of banking advisors. In Section 4.4, I describe Thailand's weak record of enforcing bank regulations during Chuan's term, and Section 4.5 addresses the regulatory performance of Chuan's successors.

Background: Bank Regulatory Governance in Thailand Before 1992

In the three decades prior to the liberalization of capital flows in 1992–93, Thailand was predominantly governed by a succession of authoritarian or semi-authoritarian regimes, that is, regimes with very few checks on the chief executive's power.

In this chapter, I demonstrate why a small difference in preferences between the chief executive and financial bureaucrats renders signals vague. I also show why the threshold difference in preferences between the chief executive and signalers that generates completely uninformative signals is relatively low in the realm of bank regulation. I begin by defining some terms. I then describe the logic that links a significant difference in preferences between the chief executive and the central bank governor to lax regulation, when the governor is the sole signaler of information collected by bank supervisors. In Section 3.3, I address the scenario in which both the central bank governor and the finance minister are signalers.

DEFINING SOME TERMS

Banking Sector Robustness

The signaling models presented here focus on a key aspect of a banking sector's robustness: the degree to which a banking sector is capitalized relative to expected loan defaults. I focus on this aspect of robustness for the signaling model because signaling considerations are important in realms where some actors have private information, and this condition is often likely to be met when it comes to the relationship between capitalization and expected defaults, for the reasons listed in Chapter 1.

As per the principles of bank accounting, a bank that has a shareholder capital buffer that is insufficiently large to cover loan defaults is considered to be insolvent.

The prediction of this book is that authoritarian environments are unlikely to be subject to either signaling or gridlock problems. Thus, unlike environments with even a moderate number of checks, we should generally observe outcomes that are consistent with the preferences of the chief executive. In this chapter I address the two countries where the chief executives adopted unorthodox solutions to the signaling problem following capital flow liberalization. In one case, the chief executive appointed a long-time friend from his home village to closely monitor the central bank and finance ministry from a special senior advisory position. In the other, the chief executive sidelined senior financial bureaucrats and instead relied on relatives and close cronies who owned banks as his primary source of information on the banking sector. In neither case is there evidence of signaling problems. The chief executives of both countries had close ties to the banking sector. The outcome, lax regulation, was in line with both chief executives' preferences.

MALAYSIA

In the years leading up to the Asian crisis, Malaysia was an authoritarian country where political power was largely concentrated in its prime minister, Mahathir Mohamad. In Section 5.1.1, I provide some background information on Malaysia's political and economic environment in the years leading up to the liberalization of capital inflows in 1990. In Section 5.1.2, I describe Prime Minister Mahathir's inner circle of banking advisors in the 1990s. In Section 5.1.3, I address the bank regulatory environment during this period.

Assume, strictly for the time being, that the chief executive has a posterior belief that the signaled value of z is true only when the messages sent by both signalers agree. Assume, also strictly for the time being, that when the messages disagree he believes that z lies between ϖ − 2xs1 and ϖ + 2xs1. (At the end of this section, I demonstrate that these beliefs are consistent with the senders' strategies.)

Given the above posterior beliefs, the chief executive will find it optimal to choose k = z when the messages agree. This is the case because, given that x = k − z, k = z will yield x = 0, which is his ideal point. Both senders will prefer to signal the true value of z, if the chief executive's choice when the messages do not agree will yield a value of x further from both their ideal points than xc. Because ω is uniformly distributed, and given that when the messages disagree the chief executive believes that it lies between ϖ − 2xs1 and ϖ + 2xs1, the chief executive's choice of k when the messages disagree is ϖ. (This choice maximizes his expected utility when z lies between these values, because it minimizes the expected distance of x from his ideal point.) Given that x = k − z, the chief executive's choice of k = ϖ when the messages disagree yields outcomes that are to the left of −2xs1 when z < ϖ + 2xs1 and to the right of 2xs1 when z < ϖ − 2xs1.

We now live in a world where capital often moves freely across national borders. In this world, developing countries have increasingly been subjected to devastating financial crises caused by the sudden withdrawal of foreign capital. These crises have had severe humanitarian consequences; in East Asia in 1997–98 some countries experienced economic contractions comparable to levels seen in the Great Depression. How do such crises come about? I focus on a novel causal path, that of miscommunication. I demonstrate why developing democracies are exceptionally vulnerable to breakdowns in communication between financial officials and the chief executive. These breakdowns have disastrous consequences because they result in inadequate bank regulation, which encourages the withdrawal of foreign capital.

This book contributes to three literatures. The first is the literature on globalization of capital. This literature has hitherto paid little attention to how globalization can have disastrous consequences in political environments where there are problems in the credible communication of financial information, and this is a contribution of my book. The second is the literature on the politics of financial crises. It is plausible that the presence of ill-informed chief executives raises the likelihood of financial crises. However, scholars of crises have hitherto been unable to systematically identify where we are likely to observe an ill-informed chief executive, thanks to the absence of any preexisting analytical framework for such an analysis.

In this chapter, I address the two authoritarian countries where chief executives adopted the orthodox solution to the signaling problem, namely, to appoint close associates who shared their preferences to key bureaucratic positions. In both cases, the regulatory outcomes were in line with the chief executives' preferences for stringent regulation.

SINGAPORE

Recall that an authoritarian country whose chief executive has arm's length relations with the banking sector is predicted to have a stringent bank regulatory environment, unimpeded by signaling problems or gridlock. I show in this chapter that, although Singapore changed its development strategy several times in the course of the last three decades, there was one constant: arm's length relations between the chief executive and the entire business community, including the banking sector. I begin with a background section that addresses the period between 1965 and 1990, when Lee Kwan Yew served as the chief executive. In Section 6.2, I describe the political environment under Lee's successor, Goh Chok Tong. In Section 6.3, I describe the bank regulatory environment in Singapore in the years leading up to the Asian crisis.

Background: Singapore Between 1965 and 1990

Ever since its emergence as an independent state, Singapore has operated under a system of government that falls well short of being a democracy. The government's powers include detention without trial, deregistration and replacement of radical unions with compliant ones, and withdrawal of licenses from newspapers deemed to be opposed to national interests.